Edward K. White Charles Chaz Lavelle Gary Bowers 1320 Main Street, 17 th Floor Senior Partner Partner Columbia, SC 29201 Bingham Greenebaum Doll LLP Johnson Lambert, LLP Direct:502-587-3557 ed.white@nelsonmullins.com 502-587-3557 919-719-6411 803-255-9559
Rent-A-Center Rent-A-Center is a public company which rents furniture, etc. to the public. From the Briefs filed (not the opinion), Rent-A-Center had 3 to 12 subsidiaries [depending on the year], but in each year, one accounted for 61 to 68% of the total premiums of the captive. Captive insured the deductibles of Rent-A-Center s G/L, Auto and Workers Comp Commercial insurance program. Some commercial carriers declined to write the captive coverages or would do so only at a much higher price 2
Rent-A-Center (cont d) Rent-A-Center is a public company which rents furniture, etc. to the public. From the Briefs filed (not the opinion), Rent-A-Center had 3 to 12 subsidiaries [depending on the year], but in each year, one accounted for 61 to 68% of the total premiums of the captive. Captive insured the deductibles of Rent-A-Center s G/L, Auto and Workers Comp Commercial insurance program. Some c 3
Rent-A-Center (cont d) The captive charged a premium, which was internally allocated to the subsidiaries (although from the briefs, it appears the allocation could not be replicated) Rent-A-Center deducted premiums paid in the following September under the recurring item exception and provided parental guarantees to the captive s regulator relative to some deferred tax assets. Captive purchased Treasury shares of parent company as an investment The Plurality opinion found that there was no sham and that there were legitimate non-tax reasons Rent-A-Center had common notions of insurance, shifted risk (even with the guarantee)and met the balance sheet test 4
Rent-A-Center (cont d) The opinion looked at the exposure units, not concentration The concurring found the premiums actuarially determined The principal dissent found the captive did not operate as a real insurance (e.g., guaranty, undercapitalized, illiquid [Treasury shares]) On January 21, 2014, the Tax Court held that Rent-A-Center had a valid insurance arrangement for Federal tax purpose on a 10-6 vote. The IRS choose not to appeal. 5
Securitas Securitas AB is a Swedish security company (AB) with a US Holding Company (US) that acquired Pinkerton s, Burns Security and other security companies US owned two captives: Protectors and Centaur - Centaur was in run-off and was tax-exempt under section 501(c)(15). Protectors was a Vermont captive AB organized an Irish reinsurance company In 2004, 88% of premiums were those of one subsidiary In order to protect the section 501(c)(15) tax exemption, US guaranteed Protectors losses, which was never called upon. A loss portfolio and current risks were insured; the parties agreed they were insurance risks. 6
Securitas (cont d) The Tax Court determined that the guaranty did not invalidate risk shifting; parental guarantees do not automatically invalidate a captive arrangement. Protectors was adequately capitalized and the offset of premiums and claims did not adversely affect the insurance arrangement and risk distribution is evaluated from the perspective of the captive. The Tax Court focused on the number of statistically independent risk exposures 100,000 US employees and 2,240 vehicles, rather than the number of entities 7
Securitas (cont d) Opinion quoted Dr. Doherty, the taxpayer s expert, who said: It is the pooling of exposures that brings about the risk distribution -- who owns the exposures is not crucial. The Tax Court found that the arrangement was insurance in its commonly accepted sense because: The captives were organized, operated and regulated as insurance companies and were adequately capitalized The policies were valid and binding and premiums were reasonable and losses were paid (after offset) 8
Residual Value Insurance TAM 201149021 9 Lessors leased equipment to customers with a projected value of $x For example, a rental car company may lease fleets of cars totaling 2,000,000 cars or a computer company may lease 2,000,000 computers Real estate was also involved The lessor purchased insurance from an unrelated insurance company to pay to the extent the actual value of the equipment is less than $x (excluding physical damage)
Residual Value Insurance TAM 201149021 10 TAM 201149021 determined that this is not insurance it is not an insurance risk, but more of an investment risk (economic fluctuations and not fortuitous physical act) There were no common notions of insurance economic risk and gap between loss and payment There was no risk distribution the same economic issues affect the nationwide market The taxpayer involved in this tam is RVI Guaranty Ltd.
RVI Guaranty Ltd RVI Guaranty Ltd was the taxpayer involved in TAM 201149021 This is not a captive case, but it is important to captive insurance arrangements Last month the Tax Court found residual value insurance to be insurance I will be some time before the IRS has to decide whether to appeal In ILM 201511021, the IRS found foreign exchange not to be insurance. The IRS seemed to treat business risk closer to investment risk.
Proposed Section 831(b) Amendments February 9, 2015 the Joint Committee outlined proposed legislation to increase the section 831(b) limit to $2,200,000 (and index it to inflation), but with tighteners as to what captives qualified to make the election: Initially: only captives writing direct business, no more than 20% related party Eliminated from proposal on February 11 At the hearing, Senator Grassley was concerned about estate planning abuses, and asked the Treasury for a report 40
Proposed Section 831(b) Amendments, cont In response to the Senate Finance Committee concern about estate planning abuses: The industry proposed that a captive would not be eligible to make the election if it was owned by a trust or invested in life insurance The NAIC tweaked that proposal Bills were proposed in both houses, the Senate version required an IRS report by February 11, 2016 Most recent: only 5% captive ownership by a relative of the owner of the operating company No bill has passed either house 41
Employee Benefits Related or Unrelated Risk Rev. Rul. 92-93 Employer Premium Employer Owned Insurance Company Employees Pay Benefits Economic risks being insured are the risks of the Employees, not the Employer, so the risks are unrelated Facts involved life insurance coverage but ruling states conclusion is the same for health benefits coverage Insurance coverage was compensation for the performance of services 14
Reinsurance Rev. Rul. 2009-26 10,000 unrelated policy holders Insurance Company Y Reinsures 90% policy holder risks Insurance Company Z Reinsurance contract shifts underlying unrelated risks to Company Z 15
Health Benefits Sourcing and Reinsurance ØTAM 200816029 to properly evaluate whether an arrangement constitutes insurance for federal income tax purposes, it is critical to source the insurance risk ØRev. Rul. 92-93 looked to employees as the source of the risks covered by group term life insurance ØRev. Rul. 1980-95 looked to employees as the source of the risks covered by disability insurance ØRev. Rul. 2005-40 arrangement entered into with one policy holder cannot qualify as an insurance contract if the issuer does not enter into contracts with other policy holders ØRev. Rul. 2006-26 allows reinsurance of unrelated risks through a single contract ØRent a Center allowed only three policy holders and two-thirds of the risk related to one policy holder 16
Employee Benefits Rev. Rul. 2014-15 Contribution Insures Stop Loss Reinsures Employer VEBA Insurer Captive Retirees Retiree Medical Benefits Retiree health insurance risks being shifted are the retiree's risks IRS states that Rev. Rul. 2014-15 is not intended to apply if a VEBA is not involved 17
ERISA Permitted Stop-Loss Health Benefit Coverage Employer Premium Self Insured Plan Reinsures Captive Employees Pay Benefits Stop Loss Policy Payments to a related captive to fund health insurance can trigger ERISA's prohibited transaction rule Exception applies if the health benefit risks are shifted to a related captive through a stop-loss policy Premiums must be paid directly by the employer out of the employer's assets and any proceeds from the policy must be paid directly to the employer 18
Health Benefits Captive Issued Medical Stop Loss Policy Need to pay attention to IRC 162(m)(6) which limits deductions for compensation to officers, directors, etc., to $500,000 per annum 19
Tax Return Positions 1. Avoid 20% substantial understatement of income penalty if either: a) substantial authority for the position or b) position had a reasonable basis and adequately disclosed 2. Avoid 20% negligence penalty if have a reasonable basis for the position 20
Economic Substance Doctrine IRC 7701(o) contains a two-part test: (1) "the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and" (2) "the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction." 20% accuracy related penalty for a disallowance of a deduction without economic substance and no reasonable cause exemption. 40% penalty if there was a failure to disclose. 21
Document Ongoing Business Purpose Review goals of having a captive and annually document whether captive is achieving those goals, or if not why not Where goals are changing document reasoning behind the changes on a contemporaneous basis 22
State and Local taxes
State and Local Taxes Background Premium taxes imposed by captive jurisdiction Direct placement taxes Taxation of captive income 24
State and Local Taxes Two Types: Premium Taxes in domicile Direct Procurement Contemplates insured directly accessing unlicensed, unregulated insurer Statutory provisions Direct placement laws Industrial insured exceptions Non-Statutory Provisions 25
UPS v State of Indiana Case was about whether the captive insurance companies were subject to the premiums tax and if so, exempt from the corporate income tax 26
UPS v State of Indiana UPS was challenging the physical presence requirement of the premium tax Challenged the income tax under the Commerce Clause 27
UPS v State of Indiana Court held that the physical presence test is appropriate for the premium tax based on: US Supreme Court holding in Todd Shipyards Corp. Indiana and other state jurisdictions Commerce Clause challenge was denied on the basis of the Supreme Court s interpretation of McCarren-Ferguson Act 28
Wendy s v State of Illinois Case was a challenge to Wendy s exclusion of its captive insurance company from the income tax base of the consolidated return Illinois tried to argue that the captive was not an insurance company under the IRC 29
Wendy s v State of Illinois Scioto was formed in VT to write a more comprehensive program for Wendy s and BI coverage VT required sufficient capitalization to cover all insurance obligations including CAT coverage Scioto acquired an affiliate of Wendy s that held Wendy s trademark 30
Wendy s v State of Illinois Scioto survived two IRS audits on the issue of whether it was an insurance company The acquired affiliate generated $389M in royalty income and Scioto wrote $20M in premiums Illinois argued that the majority of income was from royalty not insurance 31
Wendy s v State of Illinois Court held on the income issue that it was the character of the business conducted not the percentage of income that determines what a company does Held Scioto was licensed as a insurance company in VT and that they owned the affiliate to meet capitalization requirements 32
Wendy s v State of Illinois Therefore, the income should be excluded from the Illinois unitary return as Scioto was an insurance company. 33
Costco v State of Oregon Costco filed Oregon consolidated excise tax returns but excluded its wholly-owned captive insurance company Oregon challenged and concluded that the insurance company was unitary and should be included 34
Costco v State of Oregon Captive was a Bermuda entity and had made a section 953(d) election Captive received premiums from Costco affiliates and reinsurance premiums from Green Island Captive had no connection to Oregon 35
Costco v State of Oregon The Court concluded that the Oregon unitary tax rules were applicable to the insurance company and that Costco was required to include the income of the captive in the consolidated return. 36
Texas Rule 3.835 Ruling: A 4.85% tax is assessed on nonadmitted Captive Insurance Companies Captive insurer is defined as an insurance company that is formed for the purpose of insuring the risks of entities that are related to it through common ownership. These may be referred to as single-parent, in-house, or pure captives. The taxpayer must allocate the premium using the allocation standard that most reasonably and equitably apportions the premium applicable to the risk in Texas, other states, and nontaxable jurisdictions based on the type of policy. In the case of an indemnity policy that reimburses the insured for losses paid, the location of the risk or exposure insured is the location of the insured's home office.
New York Combinable Captive Insurance Company: For those Captive meeting the following criteria, they must be included in the Parent s NY income tax return and be subject to NY income tax. Combinable Captive insurance company means an entity that is treated as an association taxable as a corporation under the internal revenue code (a) more than fifty percent of the voting stock of which is owned or controlled, directly or indirectly, as a corporation under the internal revenue code and not exempt from federal income tax; by a single entity that is treated as an association taxable (b) that is licensed as a captive insurance company under the laws of this state or another jurisdiction; (c) whose business includes providing, directly and indirectly, insurance or reinsurance covering the risks of its parent and/or members of its affiliated group; and (d) fifty percent or less of whose gross receipts for the taxable year consist of premiums from arrangements that constitute insurance for federal income tax purposes.
Indiana House Enrolled Act No. 1206 Beginning with calendar years after 2012 a $2,500 tax is due to the treasury of Indiana for certain captive insurers: Captive Insurer means a foreign or alien company: That is supervised in the foreign or alien jurisdiction; That is owned by a person who conducts business in Indiana; Whose exclusive purpose is to insure property and casualty risks of: The parent entity Affiliates of the parent; or Controlled unaffiliated business That has not more than $2,000,000 of annual direct premium